The Court of Appeals of Georgia held that a liquidated damages provision in a convertible note was a penalty and therefore unenforceable when the damages under the contract included a "Failure to Deliver Daily Penalty,: and Default-Conversion and Make-Whole provisions, which recalculated shares owed under the note into a cash value based on a predetermined formula. J.P. Carey Enterprises, Inc. v. Cuentas, Inc., A21A0703, 2021 WL 4738600 (Oct. 12, 2021).
Specifically, the note was for $70,000.00 at 8%. Id. at *1. Under paragraphs 4 (a) and (b) of the note, Cuentas was to either pay JPC $70,000 plus eight percent interest by August 2, 2017, or issue JPC stock in Cuentas equal to the principal plus then-accrued interest within three days of a demand by JPC to convert the note to shares. Id.
The note outlines two specific remedies in the event Cuentas fails to deliver shares within three days of JPC issuing a Notice of Conversion. First, the note imposed what it characterized as a “penalty” of $250 per day beginning on the fourth day after notice and increasing to $500 per day upon the tenth day. Id. at *2. Paragraph 8 then provides that upon default “interest shall accrue at a default interest rate of 24% per annum.” Id. Second, the note includes what it terms a “Make-Whole for Failure to Deliver Loss” remedy which provides:
At [JPC's] election, if [Cuentas] fails for any reason to deliver to [JPC] the conversion shares by the 3rd business day following the delivery of a Notice of Conversion to [Cuentas] and if [JPC] incurs a Failure to Deliver Loss, then at any time [JPC] may provide [Cuentas] written notice indicating the amounts payable to [JPC] in respect of the Failure to Deliver Loss and [Cuentas] must make [JPC] whole as follows: Failure to Deliver Loss = [(High trade price at any time on or after the day of exercise) x (Number of conversion shares)]. [Cuentas] must pay the Failure to Deliver Loss by cash payment, and any such cash payment must be made by the third business day from the time of [JPC's] written notice to [Cuentas]. Id. at *2.
Georgia law provides that “[i]f the parties agree in their contract what the damages for a breach shall be, they are said to be liquidated and, unless the agreement violates some principle of law, the parties are bound thereby.” O.C.G.A. § 13-6-7. Further, under Georgia law, “[i]n deciding whether a contract provision is enforceable as liquidated damages, three factors must exist.” AFLAC, Inc. v. Williams, 264 Ga. 351, 354 (2), 444 S.E.2d 314 (1994) accord MMA Cap. Corp. v. ALR Oglethorpe, LLC, 336 Ga. App. 360, 363 (1), 785 S.E.2d 38 (2016). Specifically, “[t]he injury must be difficult to estimate accurately, the parties must intend to provide damages instead of a penalty, and the sum must be a reasonable estimate of the probable loss.” Williams, 264 Ga. at 354 (2), 444 S.E.2d 314 (punctuation omitted); accord MMA Cap. Corp., 336 Ga. App. at 363 (1).
In addition, the party who defaults on the contract has “the burden of proving the liquidated damages clause is an unenforceable penalty.” Ultra Grp. of Cos., Inc. v. S&A 1488 Mgmt., Inc., 357 Ga. App. 757, 759 (1), 849 S.E.2d 531 (2020). But the defaulting party can carry this burden by “proving any of the three factors is lacking.” Id. at 760. Ultimately, the enforceability of a liquidated-damages provision in a contract is “a question of law for the court.” MMA Cap. Corp., 336 Ga. App. at 363. And in cases of doubt, the courts “favor the construction [of a contract] which holds the stipulated sum to be a penalty, and limits the recovery to the amount of damage actually shown, rather than a liquidation of the damages.” Fortune Bridge Co. v. Dep't of Transp., 242 Ga. 531, 532, 250 S.E.2d 401 (1978); see Ultra Grp. of Cos., Inc., 357 Ga. App. at 760 (1), 849 S.E.2d 531 (noting that “[i]n close cases involving a liquidated damage clause, the Georgia Supreme Court has advocated interpreting the clause as a penalty”).
Whether Damages Are Difficult to Estimate
Georgia law has been clear for over 100 years that “[i]n [the] case of a nondelivery of stock in accordance with [a] contract, if the purchase-price has been paid, the general measure of damages is the actual or market value of the stock at the time when delivery should have been made, or, in other words, at the time of the breach of the contract.” Brandt v. Buckley, 27 Ga. App. 515, 519-20, 109 S.E. 692 (1921). In fact, the Court of Appeals stated in Brandt that “[t]he claim of the buyer for damages for the failure of the seller to make delivery is ordinarily a claim for unliquidated damages....” Id. at 519. And when the buyer has paid the purchase price, and stands on the contract, as by suing for its breach, he “must be content if the law places him in the position he would have occupied if the contract had been performed.” Id. at 520.
As a matter of first impression, the Court of Appeals looked to New York law addressing convertible notes and liquidated damages. Those New York courts have held when “the breach involves the deprivation of an item with a determinable market value, the market value at the time of the breach is the measure of damages.” LG Cap. Funding, LLC v. CardioGenics Holdings, Inc., 16-CV-1215, 2018 WL 1521861, at *7 (II) (C) (1) (E.D. N.Y. Feb. 20, 2018), rev'd on other grounds by 787 Fed.Appx. 2 (2d Cir. 2019); accord Sharma v. Skaarup Ship Mgmt. Corp., 916 F.2d 820, 825 (2d Cir. 1990). Thus, the damage award resulting from a breach of an agreement to purchase securities is “the difference between the contract price and the fair market value of the asset at the time of breach, not the difference between the contract price and the value of the shares sometime subsequent to the breach.” CardioGenics Holdings, Inc., 2018 WL 1521861, at *7 (II) (C) (1) ; accord Sharma, 916 F.2d at 825; LG Cap. Funding, LLC v. 5Barz Int'l, Inc., 307 F.Supp.3d 84, 103 (III) (B) (2) (E.D. N.Y. 2018). So, the fact that the selling entity's future share value is unknowable is “irrelevant to whether actual damages are ascertainable[.]” CardioGenics Holdings, Inc., 2018 WL 1521861, at *8 (II) (C) (1). Indeed, that the quantum is unknown “does not make the damages difficult to determine.” Id. Rather, what must be ascertainable is “the measure of actual damages.” Id.
Ultimately, the Court of Appeals relying on Brandt and the several New York cases found that at the time of the breach there was a very specific market value and that was the damages that a party would be entitled to.
Whether Default Provisions Were Intended as a Penalty
Under Georgia law, whether a provision represents liquidated damages or a penalty “does not depend upon the label the parties place on the payment but rather depends on the effect it was intended to have and whether it was reasonable.”29 And it is well established that we “ascertain the intent of the parties by first looking to the language of the contract.”30 Furthermore, although the words used by the parties are not conclusive, they are “a significant factor in determining the parties’ intent.”31 Importantly, there must be “some manifestation of the parties’ intent to agree on liquidated damages.”32
Here, the Court noted that the provisions expressly call the liquidated damages as penalties. Likewise, the provisions were called penalties in evidence and testimony.
Whether the Default Provisions Were a Reasonable Estimate of the Probable Loss
The third prong of the test “inquires whether the liquidated damage amount is a reasonable pre-estimate of the probable loss.”35 In this regard, the touchstone question is whether “the parties employed a reasonable method under the circumstances to arrive at a sum that reasonably approximates the probable loss.”36 And when the amount of liquidated damages plainly has “no reasonable relation to any probable actual damage which may follow a breach, the contractual provision will be construed as an unenforceable penalty.”37 Moreover, a term fixing unreasonably large liquidated damages is “unenforceable on grounds of public policy as a penalty.”38
The Court found that prong one allowed for a proper amount of damages as the difference between the contract price and the fair market value of the shares at the time of the breach. However, the formula under the liquidated damages provision turned a $70,000.00 convertible note into an award of more than $50 million. Obviously, the Court stated this was a penalty.